Thursday, September 29, 2011

Investors 'Losing Faith in Stocks'? What Do You Expect?

The Headlines in The Wall Street Journal screeching: 'PivotPoint: Investors Losing Faith in Stocks' (Sept. 26, p. A1, A14) should not have incited wonder or puzzlement. The fact is, anyone with even a grain of common sense and financial knowledge ought to have lost faith in stocks long ago. Yet, incredibly, one still finds millions - mainly little guy investors (or those referred to as "dumb order flow" by traders) who repeat the mantra "Buy and hold" and also are as devoutly attached to the belief that "over the long term stocks return at least 9% per annum" as any any religious dogma.

To show how pie-eyed the information is, even the WSJ article actually stated:

"The new environment is one where stock returns are expected to remain below the long term averages of 9% or 10%, and prices linger at below-average valuations."

But I have news for these Wunderkinds, in fact you can expect the long term stock averages - based on the DOW - to remain about at what they were the past ten years, barely 1.3% per annum. Or not much better than a good CD, and at least with the CD one can sleep at night.

The WSJ piece also claimed that:

"Many investors began the year optimistic that recovery was taking hold"

But even then I warned repeatedly in these blogs it was all based on "smoke and mirrors":

And I cited Michael Lewis, author of The Big Short, who noted this it was all "built on quicksand". I then cited the high unemployment rate (then over 10%) and though that rate is now down to 9.1%, incredible structural defects remain - especially in the wake of the debt ceiling meltdown.

We now understand, for example, we're in an even more parlous predicament than in February, because despite the lower unemployment rate, our politicians and reps have now signed onto the austerity band wagon - which portents total financial obliteration. Indeed, there is even talk now circulating in serious circles ('The Perils of Ignoring History', by Daniel Wessel, WSJ, Sept. 29, p. A7) of a "Great Depression in 2012". One guy, a "senior U.S. policy maker" even wrote to Wessel and said:

"Promise me if you write a sequel about the Great Depression of 2012 that you'll note I was one of the guys really trying to head it off".

Wessel earlier pointed to all the failed props of the current economic environment, including: lackluster consumer spending (still laden with debt as they are), lack of housing starts, and the inability of government to break out beyond the austerity mindset that now permeates every facet of the Beltway. It is as if a pill was taken by everyone involved and they've turned into zombies, all parroting the same spending cut line. But therein lies disaster, possibly not only a lost decade such as Japan experienced in the 90s, but also another Depression. (The topic of a future blog: Why the Republicans May Desire a Depression)

Wessel then enumerates the lessons of history, including the many parallels of the 1929 crash to what may befall us next year if the government's purse strings aren't loosened. He observes, for example, that two simultaneous crises fed on each other: a banking crisis in the U.S. (as I already noted in a previous blog, bank lending has declined 1.3% ) and a "sovereign debt" crisis in Europe. (We're now seeing the same with Greece about to default, and likely bring down Italy, Portugal and Spain in a domino effect).

How were the lessons not learned then? Well, in fact they couldn't have been because it was a novel experience, but WE can learn from the ill-choices made then IF we have the mind to. The main error that Wessel documents is that the few moves that were made in the right direction were too small for the scale of the problem. In other words, the correcting forces underestimated the scale of the economic morass. Hence, the then Federal Reserve did "loosen the spigot' but too little given the financial freeze. Herbert Hoover also did push through an increase in public works, but way too small to have much effect.

that both crises(1929 and 2007-08->2011) were of the "balance sheet" sort, which require much vaster inflows of cash, stimulus. I cited Japanese economist Robert Koo (who studied the Japanese Lost Decade) and who pointedly said:

"Obama kept the economy from falling into a Great Depression. But you never become a hero avoiding a crisis. The economy is still struggling so people will say the money was wasted. Not true! The expiration of that package is behind the economy's weakness right now .Yes, the Bush tax cuts were extended last year, but tax cuts are the least efficient way to support the economy during a balance sheet recession because a large portion of the cuts will be saved or used to pay down consumer debt. Government spending is much more effective."

Thus, the Obama stimulus package, though seemingly huge (at $797b) still wasn't large enough to have the effect desired, which was to reduce unemployment to below 8%. In fact, the stats on the actual effects of the recession released two months ago showed it was far worse than anyone hitherto believed, with GDP losses in negative territory for over two months in 2008-09. This meant that the "cure" had to have been MUCH larger, maybe double the Obama stimulus. The problem is that in macro-economics the true effects are only known ex post facto, or long after the event that inspired the stimulus.

But this is exactly why NOW is the time to apply an additional stimulus, and I'd say in the vicinity of $1 trillion, preferably $1.5 trillion, and nearly all for capital works to repair our crumbling infrastructure. In the end, it doesn't matter what the DOW does if the roads to convey products across the country are falling apart, and bridges are collapsing (not to mention the sewer lines and water mains).

But don't worry, all the DOW will do for the next few months is whipsaw back and forth in increased volatility because there is nothing to prop up any real gains. Consumers are still hostage to their debts, as well as a flat income (and sliced benefits) and the government has had it hands tied by insane Tea Party -driven know nothings in the House. In this environment, things will get worse, more jobs will be lost and we may well see that Great Depression 2012.

Feeding into this the main agency will continue to be consumer lack of confidence. Having been terrified in August because of a debt downgrade, they then were forced to bear wild stock swings, major losses in their 401ks and benefits cuts - plus the threat they too may fall under the hammer- so have been spooked into pulling back. As Lynn Franco, Director of the Conference Board Consumer Research Center noted, "This does not bode well for spending".

And, if people -consumers don't spend, and businesses can't sell, so inventories grow, and profits fall - there is no basis for genuine share price increase.There is only the occasional spurious (bubble driven) basis, when the Fed plows in more cheap money, or the companies themselves buy back their own stock. But both of those are what I call smoke and mirrors. Worse, if companies can't sell their services or wares they have no choice but to let existing workers go, hence driving up the unemployment rate further. A furious feedback loop.

The final discomfiting piece in all this is the spurious trading in credit default swaps (CDS), as reported in the WSJ Sept. 28 ('A Fear Gauge Comes Up Short'). Basically, these CDS are contracts that give the buyer the right to collect a payment from the seller if a borrower defaults on an obligation. They were at the heart of the 2008 financial meltdown when more than $55 trillion were traded and most ended up on banks' balance sheets.

Meanwhile, the WSJ analysis shows these CDS are again being gamed but in a different way. While one might expect large volumes in CDS trading given recent volatility, the WSJ found the actual trades in CDS were "few and far between". The WSJ also pointed out that the "quotes market observers bandy about aren't based on actual trades at all". In other words, CDS are being exploited as financial bogeymen or fear inducers. If this is so, they may also be contributing to the ongoing volatility. As one professor of finance put it, quoted in the WSJ piece:

"This could be potentially dangerous in a very volatile and uncertain market since CDS spreads are used much more frequently and prevalently".

He went on to say, correctly:

"The market does not fully understand the limitations in trading or the lack of liquidity as CDS spreads are often quoted as readily as the Dow Jones Industrial Average".

The moral of this, and one hopes before it's too late: Just as short trades shouldn't be leveraged by totally borrowing from someone else, so fear shouldn't be leveraged using spurious CDS quotes. Small investors, already beset with market timing gimmicks, and information conveyed to big investors before they get it -not to mention flash trading- have no business in the stock market if they can't afford to lose that money.

About Me

Specialized in space physics and solar physics, developed first astronomy curriculum for Caribbean secondary schools, has written thirteen books - the most recent:Fundamentals of Solar Physics. Also: Modern Physics: Notes, Problems and Solutions;:'Beyond Atheism, Beyond God', Astronomy & Astrophysics: Notes, Problems and Solutions', 'Physics Notes for Advanced Level&#39, Mathematical Excursions in Brane Space, Selected Analyses in Solar Flare Plasma Dynamics; and 'A History of Caribbean Secondary School Astronomy'. It details the background to my development and implementation of the first ever astronomy curriculum for secondary schools in the Caribbean.